The Glass Ceiling on Rates

With the debt-to-GDP ratio at historic highs, the Fed doesn’t have much room to maneuver on the federal funds rate.

Global CIO Commentary by Scott Minerd

The release this week of the minutes from the Federal Reserve’s Jan. 28 meeting sparked a frantic hunt for fresh clues about the timing and pacing of a federal funds rate hike. The question no one seems to be asking is once the Fed commences down the road of raising rates, how far will they ultimately go? Based on research we’ve conducted on the impact of higher rates on the U.S. debt burden, it appears the terminal value for the fed funds rate—the point at which the Fed stops tightening in a cycle—is around 2.5 to 3 percent, a lot lower than many people expect.

In the near-term, the stage is clearly set for the Fed to begin what it has been referring to as “policy normalization.” While consensus may be growing that the first of the coming rate increases will commence in June, I think the Fed will likely be more cautious and begin its “liftoff” in September. After that, the Fed is likely to raise rates by 25 basis points every other meeting. Practically, this means the overnight rate should be in the 50- to 75-basis-point range by the start of 2016.

Longer term, the Fed will likely continue to tighten at a steady pace until it nears the terminal rate in the cycle, which I believe will occur toward the end of 2017 or early 2018 in the range of 2.5 to 3 percent. Supporting such a ceiling on the fed funds rate is research that shows a close historical relationship between the debt-to-GDP ratio in the economy and the terminal fed funds rate.

At 233 percent, the amount of debt as a share of GDP, excluding the financial sector, is among the highest since data became available in 1947. Given this level of debt in the economy today, and assuming the same pace of leverage expansion for the upcoming rate hike cycle as that during the 2004-2006 cycle, a terminal rate around 2.5 percent is where the economy is likely to begin to slow to an extent that forces an end to the tightening cycle. Knowing that policymakers typically overshoot, 3 percent would be in the cards as a possible terminal fed funds rate, which is within the standard error of estimate for the model. A recession typically occurs about a year after we reach the terminal rate, so if this tightening cycle plays out as I suspect, the U.S. economy won’t face its next recession until 2018 or 2019.

Why is the end of a Fed tightening cycle a concern today? Well, the yield curve generally flattens substantially by the end of a tightening cycle. In other words, 10-year Treasuries typically trade very close to the overnight rate (maybe 25 basis points higher). Therefore, understanding the economic constraints and terminal rate value of the upcoming “normalization” process can provide long-term investors with insights into the potential ceiling on 10-year Treasury yields, as well. In this case, if our view of the terminal fed funds rate is correct at 2.5 to 3 percent, then the end of the cycle in 2017 or early 2018 could see a ceiling for the 10-year note around 2.75 to 3.25 percent—a level much lower than many investors may be anticipating.

Terminal Fed Funds Rate Falls as Debt Burden Rises

The amount of debt as a share of GDP, excluding the financial sector, is among the highest since data became available in 1947. The expanding leverage of the economy suggests that economic growth is increasingly sensitive to rising borrowing costs, as evidenced by the strong inverse relationship between the historical terminal fed funds rate and the leverage ratio of the U.S. economy at the end of each rate hike cycle, indicating that the terminal rate for the upcoming rate hike cycle should fall in the 2.5 to 3 percent range.

Terminal Federal Funds Rate at the End of Rate Hike Cycles vs. Debt Burden of the U.S. Economy*

Source: Federal Reserve, Haver, Guggenheim Investments. Data as of 2/17/2015. *Note: We assume the same pace of leverage expansion for the upcoming rate hike cycle as that during the 2004-2006 cycle.

Economic Data Releases

U.S. Housing Activity Slows

Housing starts fell by 2.0 percent in January, down to 1.07 million units. The decline was due to a drop in single-family starts.

Building permits declined by 0.7 percent in January; expectations had been for a small gain. The annualized rate of permits in January was 1.053 million.

The NAHB Housing Market Index fell for a second straight month in February, down from 57 to 55. However, the decline may be due to temporarily poor weather, as the future sales index remained steady.

Industrial production rose in January, up 0.2 percent. Utilities had a strong rebound due to winter weather, with manufacturing also contributing to the gain.

The Leading Economic Index rose just 0.2 percent in January, below expectations. Five of the 10 indicators were up, while factory orders and building permits weighed on the index.

Initial jobless claims fell by 21,000 for the week ending Feb. 14, down to 283,000.

More Optimism in the Euro Zone, Japanese Growth Disappoints

The ZEW survey in Germany continued its rebound in February, with the current situation index rising from 22.4 to 45.4 and the expectations index up from 48.4 to 53.0.

The Consumer Price Index growth in the U.K. continued slowing in January, down to 0.3 percent as the impact of fuel prices continued to weigh on the headline number. Core prices ticked up to 1.4 percent.

Japan’s export growth accelerated in January to 17.0 percent year over year, the highest in over a year. Imports were down 9.0 percent.

Japan rose out of recession in the fourth quarter, though GDP growth was lower than expected at 2.2 percent annualized, versus expectations of 3.7 percent.

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